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June 26, 2015

Repo Rate, Reverse Repo, Uses, Pricing & Types of Repo Explained

Repo is a repurchasing/repossession agree­ment
rate. Repo is a money market instru­ment, which enables collateralized short
term borrowing and lending through sale/ purchase operations in debt
instruments. Under a repo transaction, a holder of securi­ties sells them to an
investor with an agree­ment to repurchase at a predetermined date and rate. In
the case of a repo, the forward clean price of the bonds is set in advance at a
level which is different from the spot clean price by adjusting the difference
between repo interest and coupon earned on the secu­rity. In the money market,
this transaction is nothing but collateralized lending as the terms of the
transaction are structured to compensate for the funds lent and the cost of the
transaction is the repo rate .In other words, the inflow of cash from the
transac­tion can be used to meet temporary liquidity requirement in the short
term money market at comparable cost.

Repo
rate is nothing but the annualized interest
rate for the funds transferred by the lender to the borrower. General Iv, the
rate at which it is possible to borrow through a repo is lower than the same
offered on unsecured (or clean) interbank loan for the reason that it is a collateralized
transaction and the cred­it worthiness of the issuer of the security is often
higher than the seller. Other factors affecting the repo rate include, the
credit worthiness of the borrower, liquidity of the collateral and comparable
rates of other money market instruments.

A
reverse repo is the mirror image of a repo. For, in a
reverse repo, securities are acquired with a simultaneous commitment to resell.
Hence whether a transaction is a repo or a reverse repo is determined only in
terms of who initiated the first leg of the transaction. When the reverse
repurchase transaction matures, the counterparty returns the securi­ty to the
entity concerned and receives its cash along with a profit spread. One factor
which encourages an organisation to enter into reverse repo is that it earns
some extra income on its otherwise idle cash. A repo is also sometimes called a
ready for­ward transaction as it is a means of funding by selling a security
held on a spot (ready) basis and repurchasing the same on a for­ward basis. When
an entity sells a security to another entity on repurchase agreement basis and
simultaneously purchases some other securi­ty from the same entity on resell
basis it is called a double ready forward transaction.

What are the uses of Repo ?

There are a variety of advantages repos
can provide to the financial market in general, and debt market, in particular
as under:

An active repo market would lead to an
increase in turnover in the money market, thereby improving liquidity and depth
of the market; Repos would increase the volumes in the debt market as it is a
tool for funding transactions. It enables dealers to deal in higher volumes.
Thus, repos provide an inexpensive and most efficient way of improving
liquidity in the secondary mar­kets for underlying instruments. Debt mar­ket
also gets a boost as repos help traders to take a position and go short or long
on secu­rity. For instance, in a bullish scenario one can acquire securities
and in a bearish envi­ronment dispose them of thus managing cash flows taking
advantage of flexibility of repos. For institutions and corporate entities
repose provide a source of inexpensive finance and offers investment
opportunities

of borrowed money at market rates thus
earning a good spread; Tripartite repos will offer opportunities for suitable
financial institutions to intermediate between the lender and the borrower. A
large number of repo transactions for varying tenors will effectively result in
a term interest rate structure, especially in the interbank market. It is well
known that absence of term money market is one of the major hindrances to the
growth of debt markets and the development of hedging instruments.

RBI can use repo as an integral part of
their open market operations with the objective of injecting/vvithdravving
liquidity into and from the market and also to reduce volatility in short term
in particular in call money rates. Bank reserves and call rates are used in
such instances as the operating instru­ments with a view to ultimately easing
/tightening the monetary conditions.

PRICING: In
a repo transaction where there are two legs of transactions viz. selling of the
securi­ty and repurchasing of the same, in the first leg of the transaction for
a nearer date, sale

price is usually based on the prevailing
mar­ket price for outright deals. In the second leg, which is for a future
date, the price will be structured based on the funds flow of interest and tax
elements of funds exchanged. This is on account of two fac­tors. First, as the
ownership of securities passes on from seller to buyer for the repo period,
legally the coupon interest accrued for the period has to be passed on to the buyer.
Thus, at the sale leg, while the buyer of security is required to pay the
accrued coupon interest for the broken period, at the repurchase leg, the
initial seller is required to pay the accrued interest for the broken period to
the initial buyer.

Transaction-wise, both the legs are booked
as spot sale/purchase transactions. Thus, after adjusting for accrued coupon
interest, sale and repurchase prices are fixed so as to yield the required repo
rate. The excess of the coupon at the first leg of repo would rep­resent the
coupon interest for the repo peri­od. Thus, the price adjustment depends
directly upon the relationship between the net coupon and the repo amount
worked out on the basis of the repo interest agreed upon the total funds
transferred. When repo rate is higher than current yield repurchase price will
be adjusted upward signifying a capital loss. If the repo rate is lower than
the current yield, then the repurchase price will be adjusted downward
signifying a capital gain. If the repo rate and coupon are equal, then the
repurchase price will be equal to the sale price of security since no price
adjustment at the repurchase stage will be required. If the repo rate is
greater than the coupon, then the repurchase price is adjusted upward (with reference
to sale price) to the extent of the difference between the two. And, if the
repo rate is lower than the coupon then, the repur­chase price is adjusted
downward (with ref­erence to sale price). Specifically, in terms of repo rate,
there will be no price adjust­ment when the current yield on security cal­culated
on the basis of sale value ( including accrued coupon) is equivalent to repo
rate.

ELIGIBLE INSTRUMENTS Different
instruments can be considered as collateral security for undertaking the ready forward
deals and they include Government dated securities, Treasury Bills, corporate bonds,
money market securities and equity.

Broadly, there are four types of repos
avail­able in the international market when classi­fied with regard to maturity
of underlying securities, pricing, term of repo etc.

They comprise

(I) buv-sell back repo,

(ii) classic repo bond borrowing

(iii) lending

(iv) tripartite repos.

(i) Under a buy-sell repo transaction the
lender actually takes possession of the collateral . Here a security is sold
out­right and bought back simultaneously for settlement on a later date. In a buy-
sell repo the ownership is passed on to the buyer and hence he retains any
coupon interest due on the bonds. The forward price of the bond is set in
advance at a level which is different from the spot clean price by actually
adjusting the difference between repo interest and coupon earned on the secu­rity.
The spot buyer/borrower of securi­ties in effect earns the yield on the
underlying security plus or minus the difference between this and the repo
interest rate.

(ii) Classic repo is an initial sale of
securi­ties with a simultaneous agreement to repurchase them at a later date.
In the case of this type of repo the start and end prices of the securities are
the same and a separate payment of "interest" is made. Classic repo
makes it explicit that the securities are only collateral for the loan of the
cash . Here the coupon income will be accrued to the seller of the security.
Under a hold in custody repo the counterparties enter into an agreement whereby
the securities sold are held in custody by the seller for the buyer until
maturity of the repo thus eliminating the settlement requirements.

(iii) ln a bond lending/borrowing
transaction, the customer lends bonds for an open ended or fixed period in
return for a fee. The fee charged would depend on the type of underlying
instrument, size and term of the loan and the credit rating of the counterparty.
The transaction would be taken care of by an agreement on securities lending
and cash or other securities of equal value could be pro­vided as collateral in
the transaction.

(iv) Under a Tripartite repo a common
custo­dian /clearing agency arranges for cus­tody, clearing and settlement of
repos transactions. They operate under a stan­dard global master purchase
agreement and provides for DVR system, substitu­tion of securities, automatic
marking to market, reporting and daily administra­tion by single agency which
takes care of the risk on itself and automatic roll overs while does not insist
on disclosing the identities by counterparties. The sys­tem starts with signing
of agreements by all parties and the agreements include Global Master
Repurchase and Tri partitle Repo Service Agreements. This type of arrangement minimizes
credit risk and can be utilised when dealing with clients with low credit
rating.

REPO
PERIOD

Repo period could be (i) overnight
term,(ii) open or (iii) flexible. Overnight repos lasts only one day. If the
period is fixed and agreed in advance, it is a term repo where either party may
call for the repo to be ter­minated at any time although requiring one or two
days' notice. Though there is no restriction on the maximum period for which
repos can be undertaken generally term repos are for an average period of one
week. In an open repo there is no such fixed maturity period and the interest
rate would change from day to day depending on the money market conditions. In
such cases the lender agrees to provide money for an indef­inite period and the
agreement can be termi­nated on any day. Under flexible repos the lender places
funds, but they are withdrawn by the borrower as per his requirements over an
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